If you're a small business owner or self employed, a SEP IRA is a great way to supercharge your and your employees' retirement savings.
You can sock away much more than in a regular individual retirement account with a SEP IRA, and in some cases, you might be able to save even more than you could in an employer-sponsored savings plan such as a 401(k).
If you're interested in getting the most out of your retirement plans, this article will cover everything you need to know about SEP IRAs.
What is a SEP IRA?
SEP IRA stands for simplified employee pension individual retirement account. You're probably already familiar with individual retirement accounts, or IRAs. A SEP is an employer-sponsored IRA for employees. Employers contribute a certain percentage of wages to each employee's account each year, and it functions just like an IRA for each account holder. But unlike personal IRAs, the contribution limit for a SEP IRA can be much higher.
On the surface, SEP IRAs are, as the name implies, simple. But the details, such as who's eligible to participate, contribution limits, administering the accounts, taxes, and other considerations for small business owners, can make them a lot more complicated.
Who's eligible for a SEP IRA?
A small business owner or self-employed individual is eligible to establish a SEP IRA plan. But once the plan is established, the owner must offer the same retirement plan benefits to all eligible employees.
The maximum eligibility requirements an employer can make for a SEP IRA are that the employee:
- Is aged 21 years or older.
- Has worked for the employer in at least 3 of the last 5 years.
- Has received at least $600 in compensation from the employer during the year.
Small business owners are able to use less restrictive language in their plans if they choose. They can also establish the plan with different eligibility requirements (to enable themselves and current employees to become eligible), then update the plan to increase restrictions before hiring new employees.
Anyone who doesn't meet the eligibility requirements for the SEP IRA plan is excluded. Employers may also exclude the following types of employees:
- Employees covered by a union agreement and whose retirement benefits were bargained for in good faith by the employees' union and the employer.
- Nonresident alien employees who do not have U.S. wages, salaries, or other personal services compensation from the employer.
How much can you contribute to a SEP IRA?
SEP IRAs generally have much higher contribution limits than regular IRAs. While the IRS limits IRA contributions to $5,500 (in 2018), the contribution limit for a SEP IRA can be as high as $55,000. That limit will increase to $56,000 in 2019.
However, most small business owners won't be eligible to contribute that amount to their or their employees' SEP IRAs. Aside from the fixed amount limitation, contributions are also limited to 25% of wages. Simply divide the number at the top of each employee's W-2 by four. If that number is less than $55,000 (or $56,000 in 2019), that's the maximum contribution for that employee's SEP IRA.
Things get a bit more complicated for self-employed individuals who don't pay themselves a salary and get a W-2. Those who are self-employed are able to contribute up to 20% of their net earnings from employment. That's because self-employed individuals are able to deduct the contributions to their own SEP IRAs.
To calculate the maximum contribution for a self-employed person, you first have to deduct the business owner's share of self-employment tax. Self-employment tax includes Social Security and medicare taxes, and it's officially 15.3% of net income. (That number goes down as individuals exceed the social security tax limit.)
In practice, though, the self-employment income tax rate goes down to about 14.13% because it's only taxed on 92.35% of net income for sole proprietors. (15.3% of 92.35% is 14.13%.) That's in order to make things fair between sole proprietorships and corporations that pay wages and can deduct the employer's share of FICA taxes (the corporate version of self-employment tax) as a business expense.
Here's the calculation for a sole proprietor with $100,000 in net income.
Business net income
Self-employment tax (14.13%)
Self-employment tax deduction
Net earnings from employment
Maximum SEP contribution (20% of above)
In order to fully max out the $55,000 contribution limits of a SEP IRA for 2018, a sole proprietor would have to generate a net income of $286,821 or more.
An important consideration with contributions
When contributing to a SEP IRA, small business owners may be tempted to max out the 25% contribution limit. But if the owner contributes 25% of their wages to their SEP IRA, they must also contribute 25% of each employee's wages to their SEP IRAs. That can add up quickly, even with just a few employees.
Small business owners who offer a SEP IRA and want to contribute a large percentage of their paychecks to their own retirement accounts need to make that clear to their employees. It might mean offering employees lower salaries and higher retirement contributions, or the employer could hire workers as independent contractors instead of wage-earning employees.
It's also important to note that contributions are completely elective by the employer each year. If the employer has a bad year, she doesn't have to contribute anything to employees' SEP IRAs. Of course, that has the potential to disgruntle quite a few employees, who may be relying on the contribution as part of their compensation.
How to set up a SEP IRA
Setting up a SEP IRA is relatively painless. The IRS outlines three steps:
- Adopt a formal written agreement. Most financial institutions will provide an IRS-approved prototype SEP upon opening a new account. A prototype plan is simply a boilerplate plan that fits all of the IRS's requirements of a SEP. Business owners can also use IRS Form 5305-SEP to create a plan agreement or create a custom plan with more details about which employees are eligible for contributions.
- Provide each eligible employee with information about the SEP. If using Form 5305-SEP, each employee should receive a copy of the form. If using a prototype plan or custom plan, each employee should receive documentation of the agreement.
- Set up a SEP IRA for each eligible employee with a bank, insurance company, or other qualified financial institution. The employee owns and controls the SEP IRA.
Where a small business owner chooses to open the employee accounts is up to them. Many online discount brokerages offer SEP IRA accounts with no setup fees, no maintenance fees, and the same low commissions as their other brokerage accounts.
Business owners can establish a SEP as late as their tax-filing date for the fiscal year. For sole proprietors and C Corporations -- a corporate structure where business profits are taxed separately from individual owners -- that's usually April 15 of the next year. For S Corporations -- a corporate structure where profits pass through to owners -- and partnerships, that's usually March 15. Employers can also make contributions up until that date for the prior fiscal year.
How are SEP IRAs taxed?
SEP IRA contributions are fully deductible for business owners. For small business owners who pay themselves and their employees wages, contributions for employees' SEP IRAs are deducted on Schedule C, the IRS tax form detailing business profits and losses for sole proprietors, or Form 1120 for partnerships and corporations.
Importantly, sole proprietors and partners can't deduct contributions made to their own SEP IRA accounts as business expenses. Instead, they'll deduct the contributions on Form 1040, where it asks for self-employed SEP, SIMPLE, and qualified plan contributions.
Employees don't have to pay personal income tax on contributions, either. Additionally, there are no capital gains taxes paid when selling securities in the account. Capital gains taxes are taxes paid on the gains over the principle investment, and they generally have favorable rates compared to personal income tax rates. But having no capital gains taxes allows SEP IRA holders to grow their account balances tax free in the meantime.
Account holders will only have to pay taxes when they withdraw money from the account. Funds are eligible for withdrawal starting at age 59 and a half, just like with a traditional IRA. The IRS also requires minimum distributions from the account starting at age 70 and a half. Account holders will pay taxes on their withdrawals at their regular income tax rates.
People who want early access to their funds will have to pay an extra 10% tax on top of their income tax rates as an early withdrawal penalty. SEP IRA funds are intended for retirement, so the government wants to discourage early withdrawal. That said, there are some exceptions to the early withdrawal rule, including:
- A $10,000 allowance to go toward a first-time home buyer's down payment.
- Health insurance premiums paid while unemployed.
- Qualified higher-education expenses.
- Permanent disability.
- Establishing substantially equal payments.
- Death before the age of 59 and a half.
Can I have a SEP IRA and an IRA?
While they both use the term "IRA," employees can establish their own IRAs even if their employer offers a SEP IRA. There are still some considerations to take into account, though, since a SEP IRA could affect the deduction on contributions to a traditional IRA.
Individuals with a modified adjusted gross income above $63,000 (for 2018) get a partial deduction on their tax returns for IRA contributions if their employer also sponsors a retirement plan, such as a SEP IRA. That deduction goes to $0 when an individual's AGI rises above $73,000. For joint filers, those AGI numbers climb to $101,000 and $121,000.
Those with reduced deductions are better off using a Roth IRA if they're eligible. Otherwise, they may want to consider a back-door Roth IRA. The back-door Roth takes after-tax contributions to a traditional IRA and immediately rolls them over to a Roth IRA.
Using an IRA in conjunction with a SEP IRA will allow people to save even more for retirement -- and potentially get some tax savings as well.
Who should use a SEP IRA
A SEP IRA is best for small business owners with just a few close employees, or a self-employed person. The biggest drawback in a SEP IRA is that the business owner must contribute an equal percentage of compensation to each employee's plan. So, if they want to max out their own contribution, they also have to max out contributions for each employee.
That's no big deal for a single-person company. Even a few close employees (perhaps family members) could agree to lower wages in exchange for higher retirement plan contributions. But as a company gets bigger, it'll be harder to max out contributions and keep everyone happy.
SEP IRA vs 401(k)
When most people think of employer-sponsored retirement plans, they think of a 401(k). But 401(k)s require a lot more administrative work and planning than SEP IRAs. As such, they can be a lot more expensive for small business owners to offer employees.
Additionally, 401(k) plans offer account holders just a few investment options. Since a SEP IRA account works just like a regular IRA, account holders are able to invest in any kind of security they want -- stocks, bonds, mutual funds, etc.
401(k) plans typically only offer select mutual funds, often with very high expense ratios that eat into investor returns. The expense ratio is the percentage of invested assets a mutual fund takes to run the fund. 401(k)s often have additional fees that can eat into investor returns as well, such as service and administrative fees. Those fees can be especially high for small business owners and employees because they're often tied to fixed costs. With fewer employees among which to spread the costs, each participant ends up paying more.
Oftentimes, small business owners can set up SEP IRAs for themselves and their employees for free. Additionally, the simplicity of the plan means no maintenance fees at most brokerages. While there's still some paperwork and plan administration involved, it's simple enough that the business owner could do it themselves, or pay a small additional fee to an accountant to help out around tax time.
While a SEP IRA is certainly simpler and less expensive to offer than a 401(k), there's one big drawback: 401(k) plans include the option for employees to elect a contribution. That contribution limit is $18,500 in 2018 and $19,000 in 2019. Employees over 50 can elect to save an additional $6,000 as a catch-up contribution. 401(k) plans also include an employer contribution, which can range up to 25%, the same as a SEP IRA contribution. The addition of the employee election can make the plan more attractive without business owners having to contribute as much to their retirement plans.
SEP IRA vs SIMPLE IRA
If the SEP IRA isn't simple enough, the IRS also allows small business owners the ability to establish SIMPLE IRA plans. SIMPLE IRA is a backronym standing for Savings Incentive Match Plan for Employees IRA.
Like a 401(k), SIMPLE IRAs also offer elective contributions by employees. The contribution limit for 2018 is 12,500, with a $3,000 catch-up contribution for those aged 50 or older. Employers offer a non-elective contribution of up to 3% of compensation matching dollar for dollar what employees contribute. Employers can also elect to contribute up to 2% of employee compensation regardless of how much the employee contributes to the SIMPLE IRA account.
The SIMPLE IRA can solve one of the biggest challenges with SEP IRAs. The 3% maximum on matching contributions means small business owners won't have to worry about the conflict of interest in maxing out their own accounts and maximizing profits for their business. The elective contributions for employees means they can still save a good chunk of money for retirement if they want.
In some cases, employees will be able to save more for retirement with a SIMPLE IRA than with a SEP IRA. Employees with less than $56,818 in compensation per year will potentially save more with a SIMPLE IRA than a SEP IRA. They'll have greater control over the contributions as well. Sole proprietors with less than $79,032 in net income will be able to contribute more to a SIMPLE IRA than a SEP IRA.
It's important to note that SIMPLE IRAs are limited to businesses with 100 or fewer employees. There's no such limitation for a SEP IRA.
An even better option for self-employed individuals
While a SEP IRA is generally less expensive and provides more investment options than a 401(k), there's a big exception to the rule. Individual 401(k)s, also known as Solo 401(k)s, can be just as inexpensive as SEP IRAs and offer the same investment options. As a bonus, self-employed individuals can also contribute up to $18,500 (in 2018) as an elective contribution. What makes Individual 401(k) plans even more interesting is that they also have a Roth option for the employee contributions.
In other words, a self-employed person can contribute as much as $18,500 more than they would if they stuck with a SEP IRA. It requires marginally more work to keep track of employee contributions versus employer contributions, and there's also a form administrators have to send in (5500-EZ) every year when the account reaches over $250,000 in value. The potential tax savings are worth it, though.
A SEP could be part of your retirement plan
For small business owners who want a simple and inexpensive way to save for their and their employees' retirements -- and the flexibility of contributing to a retirement plan when it best suits them -- a SEP IRA is a great option. Understanding the minutia and the differences between a SEP IRA and other employer-sponsored retirement plans is key to making the right decision for which one to establish for a business. It could be the difference between very happy employees with big retirement savings accounts and unhappy employees with subpar wages and subpar savings.
This article is a good primer on the benefits and drawbacks of a SEP IRA. If you plan to open a SEP IRA for your business, you may want to consult an accountant or financial advisor to make sure you do everything by the IRS's book and the plan meets all the requirements. SEPs are, as the name implies, simple, but even simple things have a way of getting complicated when it comes to taxes.